What’s New

New US tax regulations results in no changes to current tax structures

Both MANULIFE US REIT (SGX:BTOU) and KEPPEL-KBS US REIT (SGX:CMOU) announced that there is NO impact on their current tax structure from the recently released proposed US tax regulations which provided clarification on the change in the US tax act in late 2017, specifically Section 267A.

Based on the advice of multiple lawyers and accountants, the entities in Barbados which are used to repatriate cash from the US and Singapore were NOT classified as hybrid entities. If the proposed US tax regulations had classified the Barbados entities as hybrid entities, it would have meant that MANULIFE US REIT and KEPPEL-KBS US REIT would not be able to claim tax deductions on interest on shareholder loans in the US. This would have resulted in the need to repatriate cash from the US as a dividend where a 30% withholding tax was applied rather than 0% under MANULIFE US REIT and KEPPEL-KBS US REIT’s current tax structure after applying the interest exemption rule.

We understand changes in the US tax act was intended to prevent private funds who were claiming interest on shareholder loans as tax deductions in the US but treating these interest as dividends in foreign jurisdictions, thereby reducing their overall tax rate. In the case of MANULIFE US REIT and KEPPEL-KBS US REIT, the interest on shareholders’ loans was classified as interest in the US, Barbados and Singapore.

Do note that these recently released tax regulations are still subject to a final tax regulation which is expected to be promulgated by 22 June 2019. However, we understand based on historical precedence, the final tax regulation is typically no worse that the proposed tax regulations which are released and which are then subjected to further consultation.

Changes in tax rates in Barbados

In conjunction with the news on the proposed US tax regulations, we understand the Barbados government has harmonised the tax rates for international and domestic companies. The net effect for MANULIFE US REIT and KEPPEL-KBS US REIT is a potentially higher tax rate to be paid on income received by their respective Barbados entities.

Effective 1 January 2019, the entities are subject to tax ranging from:

5.5% on income received up to US$0.5m,

3.0% on income received in excess of US$0.5m up to US$10m,

2.5% on income received in excess of US$10m up to US$15m,

1.0% on income received in excess of US$15m.

Based on MANULIFE US REIT’s estimates, it currently pays c.1.5% on distributable income before income tax (for period of 1 January 2018 to 30 September 2018) and there is potential for additional tax expense of not more than 1% of distributable income before income tax.

For KEPPEL-KBS US REIT, it currently pays c.1.2% on distributable income before income tax (for period 1 January 2018 to 30 September 2018) and there is potential for additional tax expense of not more than 1% of distributable income before income tax.

In the case of MANULIFE US REIT, we understand currently income is received in Barbados via three entities associated with three shareholder loans. With the tax changes, this would result in a higher tax rate. However, there is potential to consolidate all the income received into one entity, resulting in an effective tax of c.1% as MANULIFE US REIT currently receives in excess of US$15m. In addition, we understand there is scope to increase the depreciation tax shield in the US, further reducing its overall effective tax rate.

Our thoughts

While there is potentially for a slightly higher tax to be paid by both REITs due to the increase in tax rates in Barbados, we understand should the final US tax regulations conform to the recently released proposed US tax regulations, we understand there is potential for MANULIFE US REIT and KEPPEL-KBS US REIT to revert back to their original tax structure at IPO where by cash was repatriated directly from the US to Singapore, rather than via Barbados. Under this bull-case scenario, this would translate to minimal tax to be paid on cash repatriated from the US.

Nevertheless, we believe even if there is a marginal increase in effective tax rates from c.1% to c.2%, the market should react positively to this new US tax development, as there were fears over potential an effective tax rate of 30%. This has resulted in MANULIFE US REIT and KEPPEL-KBS US REIT trading on a forward yield of c.8% and c.11%, respectively, up from mid to high 6% yield before the emergence of recent tax concerns, impact of KEPPEL-KBS US REIT’s rights issue and fears over another US office REIT listing.

Thus, with risk of a higher effective tax rate diminishing, we reiterate our BUY calls on MANULIFE US REIT (Target Price of US$0.88) and KEPPEL-KBS US REIT (Target Price of US$0.78).

Mervin SONG CFADBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/2019-01-02

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